Tuesday, February 19, 2008

Incentives cause the [financial] rot

Umair has a new post about the financial meltdown and in particular how the very people at the centre of the meltdown are walking away with massive payments. I think there is a lot about how the very incentive system used by financial institutions are at the very core of the problem.

The incentive systems are probably the single biggest cause of the problems. These systems are designed to maximise profit - which is not the same as wealth creation. The assumption that serves as the foundation of incentive systems is that the "agents" interests need to be aligned with the "owners". An assumption that I now believe is totally invalid.

The incentive systems need to promote wealth creation and not alignment of the interests. Otherwise why will an executive take a risk that has a long term payoff but will hit short-term profitability?

So how do you fix something so broken. The first is to ditch the assumption of aligning the "agents" interest with the "owners" interest. The second is to ditch the idea that a single person at the level of CEO has much effect on the overall profitability of a company. Suddenly it gets hard to justify paying ANYONE 100m salary. Indeed, CEOs make a mockery of their own job - if the share price goes down its due to the market, but if it goes up its due to the skill of the CEO. Spot the paradox?

Can the market sort this out itself? Probably not. Too much self-interest. This leads to the requirement of regulation. The key is to regulate well but lightly. Some regulation will require the out-right banning of current practices, while others are about increasing transparancy and market efficiency.

Golden parachutes need to be banned. Why a CEO should receive money to leave a job is beyond me. The sub-prime crisis has shown this for the rort it is. Which does lead to the second requirement of having all senior management and possibly contracts above a certain value requiring the agreement of a quorum of shareholders. The current negogiation world is far to cosy.

In terms of increasing transparancy, the renumeration and contracts of senior management should be published. This works fine but it helps to have this put in perspective of the how well the company is paying its employees. So companies should be required to publish the various renumeration bands, the requirements for bonuses at these bands and the number of employees per band.

But perhaps the biggest change is to remove incentive schemes that promote short-term profit over long-term wealth creation. Most of the current methods can and are easily gamed. Whether it is EPS, dividends, profit, revenue or share price increase. Most of these items are reflective of things beyond the senior managements control. So the first step is to only use measures that are effected by senior management actions. More important is only use actions that promote wealth creation (as opposed to profit).

So what measures could be used?

  • Employee productivity per unit cost
  • Throughput per unit cost
  • Employee statisfaction
  • Revenue growth per unit of productivty
  • Productivity growth per employee
And there are more. Most of these measures are harder to game but they are all measuring changes that change the long term wealth creation of the company. Funnily enough, most of these would reduce the awards of financial executives.

Incentive systems and the spiralling cost of financial executives is something that needs to be addressed. Otherwise you run the risk of societal unrest. Perhaps more importantly these spiralling costs are also a distortion of the market causing the mis-allocation of resources and dragging down GDP growth.